What is Comparative Advantage Theory
Comparative Advantage is the international trade theory that focuses on the relative advantage or comparative advantage instead of absolute advantage. The country that has the comparative advantage is a country that can produce a good or service with a lower opportunity cost than any other country producing it.
The theory of comparative advantage suggested the country that have the absolute disadvantage in the production of two goods to produce a good in which it has less absolute disadvantage.
The theory of comparative advantage is one step further by exploring what if one country has the absolute advantage in the production of all goods, and another one has the absolute disadvantage in the production of all goods.
To put it simply, the theory of absolute advantage is suggested a country produces and export a product that they can produce with more efficiently compared to any other country. But the comparative advantage is suggested to produce a product with lower opportunity cost than any other country producing it.
Comparative advantage theory use the opportunity cost as a factor to compare between different options for production. The opportunity cost is the cost of pursuing one activity at the expense of another activity.
The principle of comparative advantage is as long as the relative opportunity costs of producing goods is different among countries, then there are potential gains from trade those goods.
Key Points
- The country that has comparative advantage is a country that can produce a goods or service with lower opportunity cost than any other country producing it.
- David Ricardo developed a theory of comparative advantage in 1817 to demonstrated that the limitation of absolute advantage is that the less efficient nation cannot be equally less efficient in the production of both goods.
Example of Comparative Advantage
Assume that the world had two countries and two products. Suppose that the United Kingdom and the United States, both are equally endowed with 1000 units of resources. They can produce the quantities of rice and cloth as the following table.
As you can see, the United States has an absolute advantage in both productions of rice and cloth. In other words, the United Kingdom has an absolute disadvantage compared to the United State.
Compared to the United Kingdom is less inefficient in producing rice than cloth.
- Cloth is 40% (2/5) as efficient as the US.
- Rice is 80% (4/5) as efficient as the US.
From this situation, David Ricardo might suggest the United Kingdom should produce rice. The other words, the United Kingdom has a comparative advantage in producing rice.
History of Comparative Advantage
In 1817, David Ricardo developed the theory of Comparative Advantage in his book “Principles of Political Economy” by took Adam Smith’s theory of absolute advantage one step further.
David Ricardo’s comparative advantage theory demonstrated what if one country has an absolute advantage in the production of all goods, while another country has an absolute disadvantage in all production of all goods. The country can still choose to specialize in the production of goods with comparative advantage.
David Ricardo argued that even international trade create benefit for both countries with a positive-sum game, or one in which both countries win from engaging trade. But only limitation is that the less efficient nation cannot be equally less efficient in the production of both goods.
Compare to absolute advantage, the theory of comparative advantage seems counterintuitive. However, the comparative advantage theory is far more realistic and useful in real world.
Frequently Asked Questions
The country that has the comparative advantage is a country that can produce with lower opportunity cost.
The absolute advantage is focused in produce a good with more efficiently compared to other countries. But the comparative advantage is focused on produce goods with lower opportunity cost.
